Skip to content

FRM Part II · FRM Exam Part II · Expectations, Risk Premium, Convexity and the Shape of the Term Structure

An analyst observes an upward-sloping spot curve and states that, because forward rates exceed current spot rates, the market expects short rates to rise by exactly the forward-spot gap. Which statement best describes the validity of this claim under the framework in the reading?

The claim holds only if there is no risk premium. When investors demand a positive term premium for holding longer bonds, forward rates exceed expected future short rates, so the forward-spot gap overstates the rate rise the market actually expects.

  1. AIt is valid only if forward rates embed no risk premium; with a positive term premium, the forwards overstate expected future short ratesCorrect
  2. BIt is valid always, because forward rates are unbiased predictors by arbitrage
  3. CIt is invalid because forward rates understate expected future rates whenever the curve is upward sloping
  4. DIt is invalid because forward rates are unrelated to expected rates under any hypothesis

Explanation

Forward rate = expected future rate + risk premium (and convexity effects). With a positive risk premium, the forward exceeds the expectation, so reading forwards as pure expectations overstates expected rate increases. Arbitrage fixes forwards from spots, not their predictive power.

Did you get it right without looking?

One question tells you little. A timed set on Expectations, Risk Premium, Convexity and the Shape of the Term Structure shows your real accuracy, how long you take and where you lose marks.

Practise Expectations, Risk Premium, Convexity and the Shape of the Term StructureFree diagnostic mock

More Expectations, Risk Premium, Convexity and the Shape of the Term Structure questions